Understanding Forex Forward Transactions

2017-09-06 15:54    forextraders

A forward transaction in the foreign exchange market is a contractual agreement to take part in a currency transaction on a date other than the spot value date at a specific rate of exchange. More on the spot transaction.

Since a forex deal settling in two business days (or one for USD/CAD) is generally considered a spot deal, this means that forward value dates will usually settle more than two business days from the transaction date.

The Forward Market

Forward contracts are typically transacted in the Over-the-Counter or OTC forward market between counterparties that work out the contract’s terms among themselves, usually over the telephone.

Also known as a forward outright contract, forward contract or forward cover, a forex forward transaction generally involves buying one currency and selling another at the same time for delivery at a particular rate on the same date (other than spot).

The Interbank forward market generally trades for standardized value dates, sometimes called straight dates, like one week, one month, two months, three months, six months, nine months and one year from the spot date.

Forwards with value dates that do not conform to these straight dates are sometimes called odd date forwards. They are used by many bank customers who may ask for forward contracts with dates tailored to their specific hedging needs.

The forward prices for odd dates are usually determined from the pricing for the surrounding straight dates that can be readily obtained from the market.

The Forward Value Date

The forward value or delivery date is simply the agreed upon date for mutual delivery of the currencies specified in a forward contract. This date can be days, months or even years after the transaction date.

As a result of this flexibility in value dates, a forward contract can easily be tailored to meet a hedger’s specific currency delivery needs based on their expected currency cash flows.

Furthermore, how the exchange rate moves between the forward transaction date and its value has little impact, other than perhaps from a credit risk standpoint. This is because the counterparties have already agreed upon a rate of exchange for the currencies involved that will be used when the value date for settlement of the currencies finally arrives.

Executing a Forward Transaction

Since the value of forward contracts moves more or less in tandem with the spot rate, executing a forward transaction usually involves first doing a spot trade in the desired currency amount to fix that more volatile portion of the forward price.

To then obtain the forward rate, the counterparties will add or subtract from the spot rate the forex swap points for the desired forward value date that pertain to the particular currency pair involved.

Forwards and the Cost of Carry

The forex swap points are determined mathematically from the net cost involved in lending one currency and borrowing the other during the time frame covered by the forward contract. This is often known as the “cost of carry” or simply the “carry”.

The swap points are therefore based upon the number of days between the spot value date and the forward contract’s value date, as well as on the prevailing interbank deposit rates for the forward value date that pertain to each of the two currencies involved.

In general, the carry will be positive for selling the currency with the higher interest rate forward and will be negative for buying the currency with the higher interest rate currency forward. The cost of carry will be more or less neutral for pairs of currencies that have the same interest rates.


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